The bond market is ignoring Janet Yellen and setting up a TIPS trade

When Federal Reserve Chairwoman Janet Yellen shrugged off a recent rise in inflation this week, she may have set up an opportunity in the sleepy market for Treasury inflation-protected securities.

TIPS, as they are known, protect against rising inflation, with the securities growing in principal alongside rising consumer costs as measured by the consumer price index. Inflation barely existed last year, so investors fled the asset class, leading the way in a broader selloff in the Treasury market.

Bloomberg

Janet Yellen, chairwoman of the U.S. Federal Reserve

But TIPS have stabilized this year amid signs of rising inflation — and Yellen’s comments during a press conference this week could signify more gains to come for the recovering market, according to Wilmer Stith, co-manager of the Wilmington Broad Market Bond Fund.

Inflation has been on the rise, with the Labor Department’s CPI outperforming forecasts in recent months. CPI rose by an unadjusted 2.1% over the past 12 months, data for May showed on Tuesday. That added to questions for the Fed, which has an annual 2% target rate for inflation.

But Yellen seemed unconcerned about the return of cost pressures. She said:

“I think recent readings on, for example, the CPI index have been a bit on the high side, but I think the data that we’re seeing is noisy. I think it’s important to remember that broadly speaking, inflation is evolving in line with the committee’s expectations.”

Some investors think those comments mean the Fed is behind the curve, responding to inflation only after it gets out of hand. Those in the TIPS market aren’t waiting to react to the CPI reading.

“The market is going to be pressing and saying this isn’t just noise,” said Stith.

One way to measure market expectations of inflation is by looking at breakeven rates, the term for the yield difference between an inflation-protected security and its plain-vanilla counterpart. That also doubles as a market expectation of inflation because it represents the annual CPI rate that is necessary for TIPS to outperform nominal Treasurys. In recent weeks, breakeven rates have climbed, and the 10-year rate currently projects inflation of a 2.29%, according to Tradeweb. Here’s what that looks like:

Of particular mention is that TIPS investors and the Fed are looking at different indicators. TIPS are based on CPI, which continues to climb, while the Fed likes to use personal consumption expenditures, which stills lags the Fed’s target. In April, it had an annual reading of 1.4% – still well below 2% – and the next data is due out on Thursday. That disconnect means the Fed may let CPI continue to rise past 2% before acting to rein it in, Stith notes.

If CPI keeps climbing, TIPS only look more attractive. And if the Fed is willing to overlook rising inflation, or at least wait until its preferred gauge hits the target, TIPS could see growing demand, Stith says.

Already they are getting more expensive, with the 10-year TIPS yield dropping from 0.418% on Tuesday to 0.328% on Friday. The nominal 10-year Treasury note
/quotes/zigman/4868283/delayed10_YEAR yield dropped form 2.653% to 2.621% during those days.

Despite the disconnect between gauges, cost pressures may be beginning to rise across the board, helped along by rising oil costs amid intensifying conflict in Iraq. That could be a tipping point for the broader investing community to take notice. As Jonathan Gibbs, head of real returns at Standard Life Investments, puts it: “It doesn’t matter until it does.”

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